Financial institutions are often referred to as the knight in shining armor in a rising interest rate environment. With profit margins that expand as rates climb, entities like banks, insurance companies, brokerage firms, and money managers generally benefit from higher interest rates. As banks reported worse than expected earnings at the start of this year along with the collapse of SVB Financial Group (Silicon Valley Bank) and Signature Bank, we questioned the accuracy of that description. To understand the second-largest bank failure in U.S. history, we need to first understand the interest rate environment and how financial institutions benefit from rising rates.
The Interest Rate Environment
Not sure if anyone remembers or cares anymore but to remind you, a majority of the world was plagued by mask mandates less than a year ago. The COVID-19 pandemic had a pronounced and depressive effect on global financial markets. In addition to concerns by the public, the uncertainty and lack of economic activity caused the Federal Reserve to slash the federal funds rate to a range between 0% - 0.25%. For consumers and corporations this was fun and games with cheap money and a very low cost of capital. Lower interest rates make big-ticket items cheaper as businesses and corporations are incentivized to take on more debt. However, the economy must pay for this “cheap” growth at some point.
Come 16th March 2022, the payday arrived as the Fed needed to raise rates to combat rampant inflation. The Fed primarily uses the consumer price index (basket of goods the average consumer buys) to follow inflation rates. The index most recently showed an annual inflation rate of 6.4%, down from around 9% last summer. Raising interest rates leads to higher borrowing costs, which slows economic growth, which in turn helps to control inflation. This was the first time that the Fed had raised the federal funds rate since 2018. Consequently, subsequent months saw much larger hikes, enough to raise the Fed’s benchmark borrowing rate by 4.5 percentage points to its highest level since 2007. Looking ahead, the Fed has shown intent to raise rates further between 5% - 5.25%
Wouldn’t Financial Institutions Still Perform Better?
Well, yes and no. It’s not as easy as saying higher rates are better for banks. Like everything in life, there is a tradeoff that banks need to make by diversifying product lines, their customer base and the assets being held. In terms of profitability, banks hold their customer’s cash in accounts that pay out set interest rates below short-term rates. They profit off the marginal difference between the yield they generate with this cash invested in short-term notes and the interest they pay out to customers. When rates rise, this spread increases, with extra income going straight to earnings. For example, if you had invested $100 with a bank in early 2022, you may have earned 0.5% interest from the bank while the bank earns 1% on this money by investing it in short-term notes. Now, if the Fed increased the federal funds rate by 1%, the bank would earn 2% on the short-term notes but the payout to customers will stay at 0.5%. This would increase the difference between the interest being collected and paid out to customers, translating to higher profit per dollar deposited.
Now, on the other hand, since rate hikes came faster than any pace witnessed in decades, people are starting to wonder whether deposit rates will also increase. Although banks are making more money by lending it out, they’re also paying more money to get it from people in the form of deposits. A key measure banks use to measure the difference between the money they’re making from interest rates and the money interest rates are costing them is the net interest margin (NIM). At the start of the rate hike cycle and even towards the end of 2022, the term “expanding NIMS” was thrown around as banks were making more money faster as rates were rising relative to what it was costing them. Soon however, depositors looked to pull their money out and invest it at higher, more competitive rates with other institutions. Banks, which lend to multi-year debt-based securities continue to earn the same yields even as federal funds rate swelled, sometimes higher than these yields.
Whatever Happened to SVB?
Looking at SVB, total deposits rose 86% in 2021 to $189 billion and peaked at $198 billion a quarter later. They fell 13% during the final three quarters of 2022 and continued dropping in January and February.
In addition, SVB’s debt securities declined in value substantially last year. As interest rates rise, it discounts cash flows from debt securities more heavily which reduces its value. As of last year, SVB showed securities labeled “available for sale” that had a fair market value of $26.1 billion, $2.5 billion below their $28.6 billion cost. Under accounting rules, labeling the asset “available for sale” allowed SVB to exclude paper losses on their statements and treat them as unrealized losses. Further, their balance sheet also showed $91.3 billion of securities that it classified as “held to maturity” which also allow it to exclude paper losses. SVB said the fair-market value of those held-to-maturity securities was $76.2 billion, or $15.1 billion below their balance-sheet value. The fair-value gap at year-end was almost as large as SVB’s $16.3 billion of total equity.
At the start of the chaos, SVB announced it lost nearly $2 billion selling assets following a larger-than-expected decline in deposits. Shares of SVB, the parent of Silicon Valley Bank, fell more than 60% after it disclosed the loss and sought to raise $2.25 billion in fresh capital by selling new shares. It is also important to address here that this situation was selectively extreme for SVB because of its concentration in investor-funded technology company deposits and the slowdown in public and private investments over the past year. The VC-backed tech firms caused the larger bank run, out of concerns of their own liquidity in addition to major concerns about the liquidity of SVB, eventually causing the demise of financial institution.
The banking sector lost $100 billion and $50 billion of market value in the US and Europe, respectively following the fallout of SVB. However, this concern does not spillover the rest of the banking industry due to the diverse customer and asset bases of the largest banks in America. When you look at unrealized losses affecting liquidity, they stem from the largest lenders. In its annual report, Bank of America said the fair-market value of its held-to-maturity debt securities was $524 billion as of Dec. 31, 2022, $109 billion less than the value it showed for them on its balance sheet. BofA and its megabank peers can part from a lot of deposits before it is forced to crystalize those losses. Most of SVB’s liabilities—89% at the end of 2022—are deposits. Following our example, BofA on the contrary draws its funding from a much wider set of sources; only 69% of its liabilities are deposits. Moreover, as mentioned, big banks hold a range of assets and serve companies across the economy, minimizing the risk that a downturn in any one industry will cause them serious harm.
The FDIC, Treasury Department and Fed devised a plan to backstop depositors with money at Silicon Valley Bank. Depositors at SVB and Signature Bank, which was shuttered Sunday over similar systemic contagion fears, will have full access to their deposits as part of multiple policies devised over the weekend. Firstly, the FDIC’s deposit insurance fund will be used to cover depositors, many of whom were uninsured due to the $250,000 cap on guaranteed deposits. Secondly, the Federal Reserve also said it is creating a new Bank Term Funding Program aimed at safeguarding institutions affected by the market instability of the SVB failure. In support, the Treasury Department is providing up to $25 billion from its Exchange Stabilization Fund as a backstop for any potential losses from the funding program. Although the move to cover deposits seems like a bailout, we believe this decisive action is necessary to protect the U.S. economy by strengthening public confidence in the banking system.
In hindsight, we believe the collapse of SVB was more beneficial than detrimental, and of course not for SVB shareholders. First, considering rates, the Fed was expected to raise rates by 50 BPS in the upcoming meeting. However, the raise was only 25 BPS as the central bank is finally seeing the impacts of interest rates, rather than just inflation figures. Secondly, if SVB’s financials were regulated effectively, considering the customer and deposit concentration in relation to the unrealized losses, the intensity of this situation could have been diluted earlier. If anything, as the public, we have learned more than anything and understood the banking sector better. All in all, SVB has allowed us to better understand our economic landscape in addition to becoming better investors.